As well, the OECD reported on Monday that it was seeing signs of emerging growth in the eurozone, with (surprise!) Germany as the engine:

Economic growth was beginning to re-emerge in the 17-nation euro currency area, the Organization for Economic Cooperation and Development (OECD) said as it released key economic indicators Monday.

The recovery in Europe’s biggest economy, Germany, had pushed up an OECD indicator for the eurozone designed to identify turning points in the business cycle, said the organization, which represents senior Western industrialized nations.

The economic clouds are lifting and such an environment is supportive of further gains in equities (see my last post Give in to the Dark Side).

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

While everyone is focused and worried about the news flow from Europe, I am less concerned about the prospects for Greece and the eurozone. As I wrote in my last post (see Draghi, the last domino, falls), Germany is becoming increasingly isolated and expect her to start to bend on the issue of eurobonds. While they may not be eurobonds in the strictest sense, we are likely to see some sort of typical European compromise on Pan-European infrastructure bonds.

I am more concerned about the news flow out of China, which is likely to deteriorate over the next few months – and none of the negative news has been discounted by the market.

The consensus on China
Currently, the consensus view on China is that while the economy is weakening, the authorities are aware of the problem and they are taking steps to remedy the situation. Indeed, Bloomberg reported that Premier Wen Jaibao made some remarks on May 20 suggesting that more stimulus was on the way:

Chinese Premier Wen Jiabao said the government will focus more on bolstering economic growth, indicating policies may be loosened further as inflation moderates.

“The country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations,” Wen said during a tour of Wuhan, the capital of China’s Hubei province, from Friday to Sunday.

“We should continue to implement a proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth,” Wen said.

The market interpreted his comments as being growth friendly:

Wen’s remarks cited in the report, which didn’t mention concern about inflation, indicate the government might take more aggressive steps to support the economy after April data showed the slowdown may be sharper than expected. The central bank this month cut banks’ reserve requirement ratio for the third time since November to boost liquidity.

Take a look at the Shanghai Composite, which reflects this ambiguity about China’s near-term growth outlook. The index is currently testing the downside of an unresolved wedge formation, which indicates indecision. A breakout to the upside of the wedge would be interpreted bullishly while a downside breakdown would be bearish.

Turmoil beneath the surface
While the picture of the Shanghai Composite reflects this consensus view, a tour of secondary market indicators suggest that not all is well with the Chinese economy. First of all, the flash PMI release showed contraction.

Signs of economic weakness are everywhere, this analysis shows a a tight correlation between Macau gaming revenues and Chinese growth – and gaming revenues are falling.

Next door in Hong Kong, the Hang Seng Index is not behaving quite as well as the Shanghai Composite. The index rallied in February to fill the downside gap that occurred in August 2011, but the rally couldn’t overcome resistance. The index has now violated an important support zone and weakening rapidly.

Further north from Hong Kong, South Korea is an economy that is highly sensitive to global economic cycle. In particular, the South Koreans export a lot of capital equipment and other goods to China. That country’s stock market isn’t behaving well either. In fact, it’s cratering.

China has been an enormous consumer of commodities. Commodity prices have also been weakening as the CRB Index is in a downtrend and has violated an important support level.

Australia is not only a major commodity exporter, it is highly sensitive to Chinese commodity demand because of its geography. The AUDUSD exchange rate is falling rapidly.

Just to show how bad things are, the Canadian economy is similar in characteristic to Australia’s. Both are industrialized countries that are large commodity exporters. The only difference is that Australia is more levered to China, whereas Canada is more sensitive to US growth. Take a look at the AUDCAD cross rate as a measure of the forward expectations between the level of change in Chinese and American growth.

Is the shadow banking system unraveling?
The story that I have outlined so far is the story of economic deceleration in China. There is another risk that the market doesn’t seem to be focusing on – the risk of a Lehman-like catastrophe in China’s financial system. Patrick Chovanec, a professor at Tsinghua University’s School of Economics and Management in Beijing, writes:

There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate.

He went on to detail an incident of how the shadow banking system is unraveling in China:

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make). In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

OK, so China has a bunch of little AIGs. The story gets better, you have leverage on top of leverage [emphasis added]:

Zhongdan, the company in the Caixin article, took these risks one step further. It persuaded borrowers to take out bank loans based on guarantees from Zhongdan, and then hand some or all of that money back to Zhongdan to invest in Zhongdan’s own “wealth management” products:

Under the arrangement, a participating company would take out a bank loan and give some of the money to Zhongdan for investing in high interest-paying wealth management products for a month or more.

The firm then apparently put those funds to work by buying stakes in small companies such as pawnshops and investment consulting firms, according to the sources. Some of the funds went toward a U.S. consultancy that later failed.

When excesses occurred in the US with subprime lending and “liar loans”, rules were skirted. It’s no different in China.

Since this use of funds completely violated banking rules, Zhongdan forged documents indicating the money was being borrowed to pay fictitious suppliers:

To nail one loan, [an executive for a building materials manufacturer] said, Zhongdan formed a shell building materials supplier and wrote a fake contract between the supplier and his company. The document was presented to the bank, which approved the loan. Zhongdan later de-registered the phony supplier.

It all unraveled in the end.

The whole thing started to unravel in January when banks “reacted to rumors of a liquidity crunch” at Zhongdan:

At that point, regulators stepped in and told everybody to freeze — and to keep all the assets as “good” on everyone’s balance sheets while they figured out what to do next. Zhongdan had over 300 clients, and guaranteed RMB 3.3 billion (US$ 521 million) in loans from at least 18 banks. The only liquid assets that the guarantee company appears to have available to pay banks is RMB 210 million (US$ 33 million) in margin accounts deposited with the banks themselves. Good luck finding the rest:

Several banks that cooperated with Zhongdan smelled trouble and started calling loans they had issued to companies backed by the firm … The next domino fell when the creditor companies, seeking to appease the banks, turned to Zhongdan for help repaying the called loans. But Zhongdan executives balked, and the domino effect accelerated as companies teetered under bank pressure and the city’s business community shuddered with credit freeze fears.

When I hear stories like this, I think of the cockroach theory. If you see one cockroach, there are sure to be more.

Reuters recently reported a story that Chinese buyers were defaulting on coal and iron ore shipments. While this story may be an indication of a slowing economy in China and slackening commodity demand, it might have stopped there. But the story gets worse as it exposes the cracks in the shadow banking system. It turns out that Chinese buyers have been buying commodities and using them as collateral to obtain financing. When the economy and commodity prices turned down, they were caught. This type of financing is highly prevalent in the copper market, as Reuters reported that Chinese warehouse were so full that copper inventory was the red metal was being stored in car parks.

Watching the shadow banking system
I have no idea what all this means. China’s economy is highly opaque and we have no reliable statistics. How big is the shadow banking system and how much leverage is involved? We know that there are problems, but I have no way of quantifying it.

Could this result in a crash landing, i.e. negative GDP growth, in China? I have no idea. Certainly, the unraveling of excessive leverage has seen that kind of result before.

Here is one offbeat way that I am watching for signs of stress in China’s shadow banking system. I am watching the share price of HSBC. While HSBC is a global bank, it has deep roots in Hong Kong and Asia. For newbies, HSBC stands for Hongkong Shanghai Banking Company. It is a bank that was firmly established in Hong Kong. As a child, I can remember driving by the bank’s headquarters in downtown Hong Kong in the 1960’s.

Stresses in the Chinese financial system is likely to show up in the share price of major financials that have exposure to China and Asia, like HSBC. The stock has been falling rapidly in the past couple of weeks, which is not a good sign.

To put the stock performance into context, I charted the performance of the stock relative to the BKX, or the index of US bank stocks. HSBC has been in a relative downtrend, but the lows of 2009 have not been violated. I interpret this as the market signaling that while there may be signs of trouble, it is not panicking.

Chinese elite losing confidence
To add to China’s troubles, the Chinese business elite is starting to lose confidence in China’s long-term outlook. FT Alphaville highlighted a survey by the Committee of 100, an international, non-profit, non-partisan membership organization that brings a Chinese American perspective to issues concerning Asian Americans and U.S.-China relations. The results of this key question asks American and Chinese business leaders their outlook for China. While Americans believe that Chinese growth will continue long into the future, the Chinese are far less optimistic and their outlook has deteriorated rapidly since 2007.

China’s outlook in 20 years

Putting it all together, we have signs of a weakening economy, a shadow banking system that is teetering and a loss of confidence by China’s business elite. While the government is taking steps to address the problems, none of these risks have been discounted by the market.

While I expect the news flow from Europe to improve in the days to come, which is bullish, I also expect further stories of deterioration out of China, which has the potential to be extremely bearish. All this points to further choppiness in stocks and risky assets with a downward bias.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The retail sales number reported today came in mixed. The headline number came in below expectations, but the ex-auto number was strong. There were revisions everywhere.

What to make of this?

I believe that the American consumer it’s would be a mistake to think that the American consumer as down and out. The Consumer Metrics Institute produces a series of figures that tracks American consumer activity on a daily basis. The daily series shows a modest uptick.

Daily numbers are inherently noisy, but the monthly figures show a definite rebound in consumer demand.

For the final word, Nomura (via Business Insider) interpreted the retail sales report positively:

The control measure feeds into estimates for the consumer spending component of GDP and suggests a healthy round of spending to start the year. Lastly, our preferred measure of consumer comfort, the category of dining out, increased by a strong 0.6% in January. Dining out can be seen as one of the ultra-discretionary categories of spending that is typically the first place households will cut back on spending if confidence is faltering.

Remember that we are in a central bank induced liquidity rally. Last week the BoE joined the party, this week it was the BoJ. Enjoy.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The stock rally in 2012 has been characterized by a low-quality rally, or “dash for trash”. I wrote here that investors were under-invested in equities and have been rushing for the entrance. They have been chasing the low-quality high-beta names as a way to quickly increase their equity exposure.

If I am right in my thesis that we are in the midst of a buying panic, then the low-quality theme makes sense as a trade. The way to participate is through the use of the Phoenix strategy.

The Phoenix rises again?
I gave a buy list of Phoenix stocks on February 24, 2009, shortly before the ultimate bottom in the stock market in March 2009. The idea behind the strategy is to find beaten down stocks that barely survived the bear market and have the financial or operational leverage to benefit from the coming upturn.

The February 24, 2009 list produced many winners. Notable among them were household names such as the Bank of America (BAC):

Liz Claiborne (LIZ):

…and Saks (SKS):

Different macro backdrop, but still dashing for trash
This time, the macro backdrop is different. We were not in a recession, though arguably it has been a period of anemic economic growth, so the situation for many companies isn’t as dire as it was in late 2008 and early 2009. Nevertheless, Phoenix does make sense as a way to participate in the “dash for trash” theme.

With that in mind, I screen the members of the Russell 3000 for the following characteristics:

Stock price below $8 (lower quality, high beta names)

One year return of -50% or less (beaten down stocks)

Market capitalization of $100 million or more (must be “real” companies)

Net positive insider buying (number insider buys – number of insider sells > 0, which should provide some downside support should our thesis turn out to be wrong)

Important caveats and disclaimers
I know nothing about your investment objectives and risk tolerance so don’t construe this as investment advice as this may not be a suitable strategy for you.

This is obviously a high risk approach and I would take the following steps to control risk. First of all, determine how much of your portfolio you want to put into this strategy as 100% commitment is not suitable for pretty much everyone. Second, diversification is critical. I have received feedback when I last issued the call to buy into the Phoenix strategy about this stock or that stock not working out. If you do employ this strategy, you should buy a basket of these stocks and not focus on just one or two names.

Do your own due diligence on the stocks on the list. For some investors, this list could serve as a starting point to do some investigation of their own. As well, define your risk tolerance carefully, either on an individual stock basis and/or on a portfolio basis.

Lastly, this is a momentum dependent strategy that should be rented and not owned. As soon as momentum wanes, that will be the exit signal.

You’re on your own.

A shorter list
If 39 names is too much for you to think about, then I winnowed the list down to eight names by requiring that there are no insider sells (instead of just positive net insider buying) and heavy insider buying, defined as more than five insider buys within the last six months:

Since the market rally has been going on for several months, buying into a Phoenix strategy now is being late in the game. However, as equity underweight investors rush to get into the stocks, this strategy should yield some decent returns if my investment thesis is correct. One important component of this approach is to watch momentum indicators carefully. When they start to turn down, then it’s time to get out.

Be bold. This is the time to hold your nose and “rent” the junk.

Full disclosure: I am personally long ATPG and SVNT and may seek to get long the other names mentioned in the days to come.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

On Friday, US stocks had their worst day of 2012 as the S+P 500 fell by -0.69%. With market conditions overbought and sentiment surveys showing high levels of bullishness, does this mark an intermediate term top?

I don’t think so. Let’s get back to first principles on sentiment models. When investors are overly bullish, the market declines because there is no one else left to buy. Read that last sentence carefully, especially the last part. Is there anyone else left to buy?

Doug Kass thinks so, because many investors are under-invested in equities:

A re-allocation into stocks (and out of bonds) represents an underappreciated and potentially massive (and latent) demand that could easily be the catalyst for a move to all-time highs in the S+P 500 in 2012.

Mebane Faber showed this chart of AAII asset allocation on January 27, 2012 showing individual investors were under-weight equities versus their historical average. (The figures have since been updated by AAII and individuals are only at their average weight.) These readings indicate that equity weightings have much farther to run.

Last week, Barry Ritholz spoke with one technician who said that she didn’t know anyone who is bearish and even Roubini has become a bull. Ritholz then rhetorically asked, “Where are the bears?” Here is one key comment in response to his post indicating that individual investors are not excessively bullish in their portfolios [emphasis added]:

This is of interest. Helene Meisler, a technical analyst at theStreet.com, conducted a non-scientific survey which I’d guess probably got a majority of responses from the retail folks about how what they were expecting in the near future. Less than 1 in 5 reported they were positioned for further gains, with rest split between people expecting a pullback of less than 5% and a smaller number expecting a larger decline.

I find this interesting because the last I heard the “smart money” was slightly bearish and the “dumb money” was significantly, though not exuberantly, bullish. So either sentiment has changed, I was wrong and her responses drew from the “smart money” crowd, or else her survey sample was distorted in some way.

A series of “good overbought conditions”
The good news for the bulls is that tcombination of high bullishness and a market underweight is a recipe for a buying stampede.
Don’t forget that this is a central bank liquidity fueled rally. The BoE, the Federal Reserve and the ECB (through LTRO) are committed to quantitative easing. The best analogue is the QE2 rally seen in the latter half of 2010. The market experienced a series of “good overbought conditions” as it advanced.

So am I overly concerned that stocks encountered resistance for the first time and experienced its “worst” one-day decline of 2012?

No. This is a time to be buying the dips.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

As Mr. Market waits for the will they or won’t they news on Greece, he is telling me that worrying about Greece is so…last year. Despite all of the angst about a possible Greek default, the Greek stock market has been rallying and outperforming the Euro STOXX 50 in the past few weeks.

Worries in the eurozone has shifted to Portugal, whose stocks have been dramatically underperforming.

All is not lost for the bulls. The Portuguese market is staging a tactical rally and testing its downtrend line.

In addition, Portuguese 2 year yields, which had spiked above 20%, are now in retreat, perhaps indicating that Mr. Market is anticipating further relief from the ECB’s LTRO2 program.

That’s why I am relatively sanguine about the risk trade. If this is the worst that Mr. Market is worried about, it’s time to get long and stay long.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Last week, my Inflation-Deflation Trend Model moved from a “neutral” reading to an “asset inflation” reading, indicating that model portfolio should move to an aggressive risk-on trade of growth stocks and commodity producers. This is a somewhat surprising development as the Trend Model only moved to a “neutral” reading from a defensive “deflation” reading in mid-January.

The Trend Model is an asset allocation model based primarily on commodity prices. Trend following models generally don’t from one extreme (defensive) to the other (aggressive) in less than a month. From an analytical viewpoint, however, the development is not entirely unexpected as the signs of global healing are abundant.

Firstly, commodity prices have move out of a downtrend and staged an upside breakout from a wedge, which is bullish. As well, I wrote last week (see Time to ride the commodity bull) that long-term fundamentals, medium term sentiment and short-term catalysts are pointing to another bull run for commodity prices.

The global uptrend in the risk-on trade has been confirmed by most stock markets. US equities saw a well-publicized Golden Cross, which is a bullish condition that points to an uptrend in prices.

Looking around the world, there is an imminent Golden Cross in UK stocks as well.

Across the English Channel, the Euro STOXX 50 has shrugged off worries about Eurogeddon and in the process of staging an upside breakout.

The cyclically sensitive South Korean KOSPI has staged an upside breakout.

Even the Brazilian market, which had been a laggard last year, saw a recent Golden Cross.

The only fly in the ointment has been the dismal performance of the Shanghai Composite, which remains in a well-defined downtrend.

Is the Shanghai Composite signaling a dramatic downturn in the Chinese economy? I’m not sure, but I am somewhat comforted by the price action of the Hang Seng, which recently rallied above its 200-day moving average.

Considerable the upside potential
If we are indeed poised for a major bull move in risky assets, then the next question has to be, “What’s the upside potential?”

The upside potential can be quite high. Consider, for example, the resource heavy Canadian market as measured by the TSX Composite. One analog might be to think about is the market reaction after the Lehman Crisis of 2008. The Trend Model correctly moved to a defensive “deflation” reading in August 2008 and went “neutral” in late March 2009, about three weeks after the March bottom. It later moved to an aggressive “asset inflation” reading in August 2009.

This time around, the Trend Model moved to a defensive position in late August 2011, but Eurogeddon did not materialize. It went “neutral” in mid-January 2012 and flashed an aggressive “asset inflation” signal last week.

If we were to measure the TSX Composite from the March 2009 neutral signal to the market peak in early 2011, the move was roughly 6,000 points and roughly 4,000 points from the “asset inflation” signal in August 2009. So how far up can the market move up this time?

Another way to think about this is to look at the relative performance of the high-beta and recovery candidate US Broker-Dealer Index (XBD) relative to the stock market in the wake of the Lehman Crisis. From the bottom in 2008 to the peak in 2009, the XBD staged a relative rally of close to 60%.

A more logical technical target for this bull move, should it develop, would be an outperformance of roughly 30% against the market.

My inner trader is well aware of calls for a correction and he is a nervous bull. He is tempted to wait for a pullback before deploying new cash as some of the short-term measures appear overbought. Should we see a sustained up move, however, the overbought condition could be what my former Merrill Lynch colleague Walter Murphy calls a “good overbought”. An example can be found in the bullish impulse that began in late 2010 after the onset of QE2. The market began to move up and saw periods of sustained “good overbought” conditions.

In any case, enjoy the party. It promises to be a good one.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC’s Summary of Economic Projections.

Charles Schwab recently published a research note indicating that the Fed is watching inflation as measured by core PCE because it has a lower housing weight than CPI [emphasis added]:

The Fed also announced an explicit 2% inflation target for the first time in its history. This explicit inflation target also helps reduce uncertainty about policy long-term. The Fed will use the 2% annual target, based on changes in personal consumption expenditures (PCE) as their measure. The current year-over-year increase in PCE is 1.8% in the latest numbers. So they’re still a touch below those targets. Bernanke was asked in the press conference following the meetings, “why PCE and not the consumer price index?” One reason is that in CPI, housing has a far greater weight. It appears to have understated inflation during the housing bubble and may overstate it now that renting is more popular than buying. The PCE is also adjusted more flexibly to changing consumption patterns. Fed critics might also argue that annual increases in PCE also tend to be lower than changes in the CPI.

Remember, under the Fed’s new transparency initiative, we don’t have to guess what the Fed is going to do anymore and revealing their methodology. Consider these figures from the Dallas Fed for PCE, core PCE and trimmed mean PCE, which is another technique for excluding the more volatile components of the inflation rate.

Any way you look at it, core PCE and trimmed mean PCE remains stubbornly low and below the 2% target. This suggests to me that the Fed believes it has more room to stimulate without igniting an inflationary spiral. Watch this series for hints that QE3 might be moving off the table and don’t fret about signs of a cyclical rebound from economic releases like NFP.

The Bernanke Put still lives, at least for now.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Further to my post last week detailing signs of global healing, I have had a number of discussions with investors about the market outlook based on the events of 2008-2009. If we are indeed in a period of global healing, then can we expect the kinds of returns from stocks that we saw coming off the March 2009 bottom?

The answer is a qualified no.

Consider this chart of US equities spanning the periods in question. In 2008, the market crashed in the wake of the uncontrolled collapse of Bear Stearns and Lehman Brothers. In 2011, the European authorities manage to stem the panic. Both episodes are marked in the red boxes below.

Here’s the difference. In 2009, the market crashed. In 2011, the market didn’t. Moreover, many professional investors were positioned for a crash but their performance was hurt by the confusion over the political and economics of the eurozone crisis. As a result, hedge funds and the average long-only manager had a terrible 2011.

The road ahead in 2012
So what happens now?

I would like to discuss the outlook for return and risk for risky assets such as equities. First, because the market didn’t collapse in 2011 as it did in 2008, it would be foolhardy to ascribe near triple digit returns for equities going forward. If there are no accidents, such as a US recession, or a Chinese hard landing, investors should enjoy either high single digit or low double digit returns from a diversified stock portfolio.

The changing risk map
What has changed in 2012 is the map of risk. The actions of the ECB, Federal Reserve and other global central banks have effectively minimized tail risk for investors. Instead of having to worry about a market with a bimodal distribution, which Pimco manager Vineer Bhansali wrote about here, and is shown in the graph on the right below, I believe that stocks and other risky assets have returned to the classic unimodal bell-shaped return distribution shown in the graph on the left.

In other words, instead of worrying about catastrophic events, such as a Creditanstalt-like collapse, we just go back to worrying about earnings, recessions, growth, interest rates, etc. Bimodal distributions are much more difficult for professional managers to deal with because there is a single decision or event that can lead the market in two different directions. Will X default? Will the FDA decision be favorable for the company? How will the court rule in this key case that affects the survival of the company? It was largely these circumstances that led to the poor hedge fund and professional manager performance in 2011.

Unimodal return distributions, on the other hand, are far more manageable and much easier for professional investors to deal with. Modern portfolio theory is based on bell-shaped return distribution functions. Managers are well trained to manage risk in such situations and virtually everyone does it well.

What are the risks?
While I believe that equities are poised for reasonable returns in 2012, there are significant risks to the market. In the short term, I agree with Cullen Roche at Pragmatic Capitalism when he pointed out that investors appear to be overly complacent and due for a corrective pullback, a conclusion also shared by Mark Hulbert.

In the medium term, believe that there are two major macro risks that face the market in 2012. First, there is the risk of a recession in the US, which has loudly trumpeted by ECRI. While the high frequency economic releases have generally been coming in above expectations, which points to a weak but non-recessionary economy, what bothers me is that respected investors who are not permabears, such as Jeremy Grantham and Jeffrey Grundlach, have been cautious.

If the American economy were to move into recession as per ECRI, then we should be seeing its effects now. I would be watching carefully corporate guidance and the body language of management as we go through Earnings Season. Last week, earnings were generally upbeat with the exception of GOOG.

The second major macro risk facing the market is a hard landing in China. While the Chinese economy is showing signs of slowing, the authorities are also taking steps to cushion the slowdown. Most worrying though, is analysis from Patrick Chovanec that indicates that Chinese GDP growth would have been 6.6% had growth from the property sector been flat – which is a brave assumption given the sad state of the property market today. A Chinese GDP growth rate of 6.6% would likely freak out the markets as it is in hard landing territory.

What about Europe?
Conspicuous by absence in my list of macro risks is Europe. I respectfully disagree with John Mauldin when he wrote this week:

As this letter will suggest, I don’t think this is the year you want your portfolio in typical long-only funds. There is a lot of tail risk this year coming from Europe.

In the worse case, consider what might happen if Greece experienced a hard default inside the euro, given that the ECB et al appear to be ready to fight the fire:

Greece defaults.

Banks have to mark to market their Greek paper and Credit Default Swaps get paid out.

Banks become insolvent, but small depositors can get their money because of limited deposit guarantees up to X.

Insolvent banks either get merged with strong banks (not many in Europe), get taken over by their sovereigns and restructured into good bank/bad bank (i.e. taxpayers take the hit), or go bankrupt.

Some investors will get hurt, but there will be no mass panic because of ECB liquidity.

The inter bank market would likely freeze up under such a scenario until there is more clarity about which banks live and which die. In the meantime they live on emergency ECB life support.

Risk premium migrate to the sovereign bond market.

Any crisis will get contained if the ECB prints. The Germans, if they object, will be faced with a choice of a catastrophic failure vs. QE. In the end, I believe that they would choose QE.

This sounds more like a Long Term Capital Management crisis whose effects was contained, rather than a Creditanstalt event that takes down the banking system and set into motion the second leg down in the Great Depression.

We have a situation now where the P/E ratio, based on the trailing 12 months of earnings, is a mere 13. That may not be a classic trough by any means, but only 20 per cent of the time in the past quarter-century has the multiple been this low. That is something for investors to consider.

The multiple based on estimated earnings for the next 12 months – the “forward” P/E – is less trustworthy than the trailing P/E because it depends on analysts’ ability to accurately forecast the coming year. But as it stands, the forward multiple is now just a snick below 12.

In the past quarter-century, we saw only one other time when it was this low on a one-year forward basis, and that was the first quarter of 1988. A year later, the S+P 500 rallied 15 per cent.

That, too, is something to mull over.

For now, my Trend Model is showing a neutral reading and I anticipate some short-term choppiness as the market consolidates and digests the recent gains from the October lows. Beyond the short-term choppiness, equities should show some reasonable returns for the remainder of the year.

Don’t worry, be happy.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.